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Chapter 5

Chapter 5. The Information Approach to Decision Usefulness. Chapter 5 The Information Approach to Decision Usefulness. The Information Approach. Assumes securities market efficiency Investors responsible for predicting future firm performance

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Chapter 5

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  1. Chapter 5 The Information Approach to Decision Usefulness

  2. Chapter 5The Information Approach to Decision Usefulness

  3. The Information Approach • Assumes securities market efficiency • Investors responsible for predicting future firm performance • Role of financial reporting to provide useful information for this purpose • Usefulness of financial information evaluated by magnitude of security price response to that information

  4. 5.2.1 Reasons for Security Price Response • An application of decision theory model • Investors have prior probabilities of future firm performance • Investors obtain useful information from financial statements • Investors revise their probabilities • Leads to buy/sell decisions • Security price changes • Return on share changes

  5. Abnormal Share Return • Total share return = return due to market-wide factors ± abnormal share return due to firm-specific factors • Only abnormal share return can be attributed to financial accounting information • If good news in financial statements leads to positive abnormal share return (and vice versa), conclude financial statement information is useful. • To reach such a conclusion, need to separate market-wide and firm-specific returns

  6. 5.2.3 Separating Market-Wide and Firm-Specific Factors • Firm releases financial information • Most studies look at release of earnings • Use market model to estimate market-wide return on that day (or narrow window) • Assumes market efficiency • Abnormal share return during narrow window = total return – market-wide return • See Figure 5.2 for details • Continued

  7. 5.2.3 Separating Market-Wide and Firm-Specific Factors (continued)

  8. Unexpected Earnings • Investors have expectations of current earnings • Investors’ expectations are built into share price prior to release of current earnings • Assumes market efficiency • Investors will react only to unexpected earnings • Investors’ earnings expectations unobservable • How to separate expected and unexpected earnings?

  9. Estimation of Investors’ Earnings Expectations • Time series approach • Based on earnings in prior years • Analysts’ forecasts • Available for most large firms • Now the most common approach

  10. 5.3 The Ball and Brown Study • The First Study to Document Statistically a Share Price Response to Reported Net Income (1968) • Methodology Still in Use Today

  11. B&B Methodology • For Each Sample Firm: • Estimate investors’ earnings expectations (proxied by last year’s actual) • Classify each firm as GN (actual earnings > expected earnings) or BN (vice versa) • Estimate abnormal share return for month of release of earnings (month 0), using procedure of Figure 5.1 • Continued

  12. B&B Methodology (continued) • Calculate Average Abnormal Share Return for GN Firms for Month 0 • Ditto for BN Firms • Repeat for Months -1, -2,…,-11, and Months +1, +2,…,+6 • Plot Results • See Fig. 5.3, next slide

  13. B&B Results

  14. B&B Conclusion • Stock Market Reacts to Accounting Information, but Begins to Anticipate the GN or BN in Earnings 12 Months Prior to Month of Earnings Announcement • Consistent with securities market efficiency and underlying rational decision theory

  15. 5.3.2 Causation v. Association • Narrow Window Studies • Evidence that financial statement information causes security price change • Wide Window Studies • Evidence that financial statement information is associated with security price change • Narrow window studies more consistent with decision usefulness

  16. 5.3.3 Research in Years Following Ball & Brown • Does Amount of Abnormal Share Price Change Correlate With Amount of GN/BN? Yes • With Quarterly Earnings Reports? Yes • On Other Stock Markets? Yes • Response to Balance Sheet Information? Hard to Find

  17. 5.4 A Different Question • Earnings Response Coefficients (ERC) • Do characteristics of unexpected earnings affect magnitude of abnormal share return? Yes

  18. 5.4.1 Factors Affecting ERC • Risk (ß): higher ß  lower ERC • Capital structure: higher D/E  lower ERC • Earnings quality: higher quality  higher ERC • Earnings persistence: higher persistence  higher ERC • Continued

  19. 5.4.1 Factors Affecting ERC (continued) • Growth opportunities: higher opportunities, higher ERC • Similarity of investor expectations: more similar, higher ERC • Informativeness of price: more informative, lower ERC?

  20. More On Earnings Quality • How to Measure? • Conceptual: main diag. probs. of info. system • Earnings persistence: higher persistence → higher quality • Line-by-line evaluation (Ramakrishnan & Thomas (1991)) • Accruals quality (DeChow & Dichev (2002)): higher accruals quality → higher earnings quality

  21. 5.5 Unusual, Non-Recurring, and Extraordinary Items • Hierarchy of income numbers • Net income before unusual and non-recurring items, also called core earnings x x • Unusual and non-recurring items x x • Income from continuing operations, also called operating incomex x • Extraordinary items x x • Net income x x • Continued

  22. 5.5 Unusual, Non-Recurring, and Extraordinary Items (continued) • Definition of extraordinary item • Infrequent • Not typical • Do not depend primarily on decisions of managers or owners • If item is not extraordinary, it is part of operating income

  23. A Financial Reporting Problem • Manager motivation to put core earnings “in the bank” by overstating unusual, non-recurring, and extraordinary writeoffs • Overstating writeoffs overstates future core earnings • Effect is to overstate earnings persistence, thereby misleading investors • See Theory in Practice 11.1 re: Nortel

  24. 5.6 Accounting Information as a Public Good • A public good is a good such that use by one person does not destroy it for use by another person • Accounting information has public good characteristics • Use by one person does not prevent its reuse by others • Thus firm cannot charge users for accounting information • Continued

  25. 5.6 Accounting Information as a Public Good (continued) • Investors who do not pay for accounting information will demand more of it than socially desirable • Implication is that standard setters cannot be sure that an accounting policy that has a higher ERC than another is socially better. • Complicates standard setting • Still true, though, that an accounting policy with higher ERC is more useful to investors

  26. Conclusion • Security market response to accounting information supports rational decision theory and efficient securities market theory

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